Do value stocks outperform growth stocks in the U.S. stock market?

The main objective of this paper is to compare the performance of value stocks and growth stocks in the U.S. market using the enterprise value (EV) of each firm. Four portfolios are formed, and the consistency of the performance of each portfolio is examined under different market conditions. Changes in performance are also be tested using returns on equity (ROE) as a proxy of future earnings. Finally, the impact of firm size on performance is investigated. Using the stocks of 4,952 firms for the period 15 years from January 2, 1999 to December 31, 2014, it has been shown that the value stocks outperform the growth stocks. These results are not changed with different holding periods. The requirement of ROE above 5 percent has the impact on the performance of growth stocks. In terms of firm size, it appears small firms are more profitable than large firms.

Journal of Applied Finance & Banking, vol 7, no 2, 2017, 99-112 ISSN: 1792-6580 (print version), 1792-6599 (online) Scienpress Ltd, 2017 Do Value Stocks Outperform Growth Stocks in the U.S Stock Market? Chongsoo An1, John J Cheh2 and Il-woon Kim3 Abstract The main objective of this paper is to compare the performance of value stocks and growth stocks in the U.S market using the enterprise value (EV) of each firm Four portfolios are formed, and the consistency of the performance of each portfolio is examined under different market conditions Changes in performance are also be tested using returns on equity (ROE) as a proxy of future earnings Finally, the impact of firm size on performance is investigated Using the stocks of 4,952 firms for the period 15 years from January 2, 1999 to December 31, 2014, it has been shown that the value stocks outperform the growth stocks These results are not changed with different holding periods The requirement of ROE above percent has the impact on the performance of growth stocks In terms of firm size, it appears small firms are more profitable than large firms JEL classification numbers: G11, G14 Keywords: Value Investing Strategy, Value Stock, Growth Stock, Enterprise Value Introduction Various investment strategies have been developed and used by professional investors to earn high returns in the stock market Among them, value investment strategy and growth investment strategy have probably been most popular in the investment community around the world The difference between two strategies comes from different views on value ratios, such as Book/Market (B/M) ratio and Earning/Price (E/P) ratio Value investors look for stocks with high value ratios because they believe that these stocks have strong current fundamentals for the book value and earnings power but incorrectly Gangneung-Wonju National University, Korea The University of Akron, U.S.A The University of Akron, U.S.A Article Info: Received : December 5, 2016 Revised : January 3, 2017 Published online : March 1, 2017 100 Chongsoo An, John J Cheh and Il-woon Kim undervalued by the market now Hence, share prices are expected to rise in the future when the valuation error is corrected by the market Growth investors, however, buy stocks with future growth potential which can lead to a significant increase in stock prices in the long run Growth stocks are expected to be currently trading at prices higher than their intrinsic value because of the growth potential and, accordingly, their value ratios are generally low The idea behind the growth strategy is the efficient market hypothesis which states that the current stock price reflects all the information available about the firm and, therefore, the current price is most reasonable at that point of time Clearly, there are arguments on both sides and there is no “right” answer to the stock investment (Investopedia Staff, 2015) Since Fama and French (1988, 1992 and 1998) made an argument that there are permanent and temporary components of stock prices and abnormal profits could be realized by investing in value stocks, many empirical studies have been done to investigate this issue As will be reviewed in the next section, however, most of these studies used B/M ratio and/or E/P ratio which are based on the equity market capitalization to identify value stocks and growth stocks In our study, we use the enterprise value (EV) as a measure of a firm’s value instead of only using the market capitalization EV is generally measured by market value of equity plus market value of debt minus cash This has been highly advocated by investment professionals in measuring firm value For example, Faulkenberry (2015) states that enterprise value is a key metric for value investors because it best represents the total value of a company and is capital structure neutral EV can be used for calculating enterprise value ratios that provide important comparisons between companies It is also argued (Forbes.com, 2012) that, by using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued For an indicator of firm’s profitability, we use earnings before interest and taxes (EBIT) which represents financial performance of a firm better than net earnings, and as a measure of the firm value, the book value is also used The main objective of this paper is to compare the performance of value stocks and growth stocks in the U.S market over the period of 1999-2014 using EV of each firm Specifically, we examine the following four questions in this paper: Do value stocks outperform growth stocks based on a new selection method? How consistently does the performance of each portfolio behave under different market conditions? Is there any change in the performance of portfolios with the consideration of return on equity (ROE) as a proxy of future earning? Does the size of the firm matter in the performance of portfolios? Previous studies have demonstrated superior performance of value stocks, but the existence of value premium has not been properly explained yet This study will provide further evidence on the comparison of value stocks and growth stocks, and address important issues, such as market conditions, ROE, and firm size which can be useful to explain the premium (if it exists) This study will also be different from previous studies in using EV ratios instead of equity market capitalization ratios for the classification of value stocks and growth stocks Do Value Stocks Outperform Growth Stocks in the U.S Stock Market? 101 Literature Review Basu (1977) shows that value stocks with low P/E (Price/Earnings) ratios outperform growth stocks with high P/E ratios Lakonishok, Shleifer and Vishny (1994) and Fama and French (1998) also show that there is strong evidence of a value premium in returns Firms with high B/M or E/P ratios have higher average returns than firms with low B/M or E/P ratios Cheh, Kim and Zheng (2008) examine the value investing hypothesis using the P/E ratio as a benchmark in finding cheap stocks relative to their earnings streams They have found that investors can beat market averages by buying low P/E stocks and selling them after the prices of purchased stocks reach a certain level For the Japanese market, Chan, Hamao and Lakonishok (1991) and Capaul, Rowley and Sharpe (1993) demonstrate that both B/M and E/P ratios have a strong role in explaining the cross-section of average returns Athanassakos (2009), using P/E and P/BV (price to book value) in the Canadian market, found strong value premium over the period of 1985-2005 consistently in both bull and bear markets, as well as in recessions and recoveries Basically, all these studies have shown that value stocks outperform growth stocks in the market as a whole However, the explanations about the existence of value premium are divided, as noted below by Fama and French (1998): “Lakonishok, Shleifer and Vishny (1994) and Haugen (1995) argue that the value premium arises because the market undervalues distress stocks and overvalues growth stocks When these pricing errors are corrected, distress stocks have high returns and growth stocks have low returns Fama and French (1993, 1995 and 1996) argue that the value premium is a compensation for risk missed by the capital asset pricing model (CAPM) of Sharpe and Lintner (1965).” In addition, there are limitations in using B/M and E/P ratios only to form an investment strategy, and the emphasis on low prices can mislead investors Damodaran (2012) points out some of these limitations of an investment strategy using B/M or E/P ratio He finds that while high ratio stocks may include a number of undervalued firms, it may also contain other less desirable firms Those firms with prices well below book value or earnings are more likely to be in financial trouble and go out of business Investors, therefore, should evaluate whether the additional returns can be made by such firms to justify the additional risk taken by investing into these firms Greenblatt (2010) also discusses the risk of using B/M or E/M ratio Each firm has different levels of debt and different tax rates The high E/P or B/P ratios may yield riskier stocks than average stocks that have lower debt and lower tax When a firm has borrowed a substantial amount, it is possible that its stock will be traded in such a way to generate a high E/P or B/M ratio If investors pick stocks with high E/P or B/M ratio, they may end up with portfolios of the most highly levered firms with high tax burdens in each sector Methodology and Data Analyses Due to the limitations of using E/P and B/M ratios in many prior studies as mentioned in the previous section, we use a more discerning method in defining value and growth stocks In particular, the enterprise value (EV) is used instead of the price of equity which represented total market capitalization of a firm EV is important for the purpose of our study because EV takes into account both the price paid for the equity in a firm as well as 102 Chongsoo An, John J Cheh and Il-woon Kim the debt financing used to help generate operating earnings In addition, earnings before interest and taxes (EBIT) is used as a measure of the profit of the sample firms EBIT is an indication of a firm’s ability to generate profit from its operations, ignoring tax burden and capital structure which can differ across the sample firms Hence, using EBIT, the results of this study will not be subject to different levels of debt and/or different tax rates of sample firms Along with EBIT, the book value (BV) of the firm is also used in this study BV represents net worth of a firm which is the difference between total assets and total liabilities Hence, the following two ratios are used in this study to identify value stocks and growth stocks: ● EBIT/EV = earnings before interest and taxes / (market value of equity + net interest-bearing debt) and ● BV/EV = book value / (market value of equity + net interest-bearing debt), where EV is more specifically defined and measured as market capitalization + total debt + value of preferred equity + minority interest (redeemable + non redeemable) - cash & equivalents Even though the EBIT/EV multiple is not commonly used in academic research to measure a firm’s return on investment, it does have certain advantages in comparing companies First, using EBIT as a measure of profitability eliminates the potential distorting effect of differences in tax rates Secondly, using EBIT/EV normalizes for the effects of different capital structures (Investopedia.com) BV/EV ratio is a relative measure of book value and total market value of the business A low BV/EV ratio indicates that the market assigns a higher value to the company due to the earnings power of the company's assets Nearly all consistently profitable companies will have market values greater than book values (Investopedia.com 2015) Next, ROE is used as a benchmark in finding good stocks relative to their future earnings streams Certain requirements must be met to be included in sample firms whose business will be good in the future The importance of ROE in stock investment has been well recognized by practitioners (The Motley Fool, 2016): “Disarmingly simple to calculate, return on equity is a critical weapon in the investor's arsenal, as long as it's properly understood for what it is ROE encompasses the three pillars of corporate management profitability, asset management, and financial leverage By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management's ability to get the job done.” Based on the results of some prior studies, other factors which can affect portfolio performance are also considered to control confounding effects: trading frequency, market conditions, and firm’s size In terms of trading frequency, Cheh et al (2008) demonstrated that high E/P ratio vs low E/P ratio in forming an investment strategy was far more complex than it appeared They found that market conditions and trading frequency mattered in the interplay of high E/P vs low E/P stocks During the rising bull market, risk-adjusted returns of low E/P stocks were better than high E/P stocks when investors rebalanced their E/P portfolios annually But more frequent rebalancing of the E/P portfolios tended to improve the performance of high E/P portfolios, while lowering the performance of low E/P portfolios Senchack and Martin (1987) reported that the market conditions had the impact on the returns of portfolio They examined how consistently the two strategies (value and grow stocks) behaved over several market Do Value Stocks Outperform Growth Stocks in the U.S Stock Market? 103 cycles It has been found that value stocks offered better downside protection as well as comparable upside potential overall Banz (1981) reported that the size of a firm could have an impact on the return of the portfolio It has been shown that small firms generated the excess return and that, as the firms became bigger, the excess returns disappeared As the initial sample in our study, we used all stocks of 6,673 firms listed in Portfolio1234 which were supplied by Compustat, Standard & Poors, CapitalQ, and Reuters during the study period from January 2, 1999 to December 31, 2014 Stocks that were not actively traded during the period were deleted, with the final sample of 4,952 firms each year For each firm, we computed EBIT/EV and BV/EV at the beginning of each calendar year The firms were then classified into value stocks and growth stocks based on the following criteria using the program available in Portfolio123: Value portfolio: Frank(EBIT/EV) >=75 or Frank(BV/EV) >=75 Growth portfolio: Frank(EBIT/EV)